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Previous Inflation Reports
The full document, in zipped PDF file - 2.87MB
Inflation Report 2002, January - June
The Inflation Report for the first half of 20021 is submitted to the government, the Knesset, and the public as part of the process of monitoring the course of inflation and adhering to the inflation targets set by the government, and is intended to increase the transparency of monetary policy. Transparency in the management of macroeconomic policy (fiscal and monetary) is an important component of the certainty needed by foreign and Israeli investors.
In August 2000 the government decided on the path of the inflation targets for the next few years, setting the target for 2002 within a range of 2-3 percent and at the conclusion of the process, in 2003 and subsequently, at 1-3 percent annually, defined as price stability.
In the first half of 2002 the CPI rose by 6.3 percent, and for the year as a whole it is likely to deviate by up to 4 percent from the upper limit of the inflation target range.
In view of the deepening recession, the government decided towards the end of 2001 to revise the growth forecast underlying the budget, reducing it significantly (relative to the original 2002 budget proposal), while setting a deficit target for 2002 of 3 percent of GDP and a return to a declining deficit path with a target of up to one percent of GDP in 2005. In this context, the following package of policy measures was agreed upon: the Bank of Israel would cut its key interest rate by 2 percentage points and some structural measures would be introduced in the money and foreign-currency markets in order to accord the Bank of Israel greater effectiveness in the use of monetary instruments, further liberalize the foreign-currency market towards the completion of the process at the end of the year, and serve to make the exchange-rate regime more flexible. The assessment was that given these conditions long-term interest would decline and it would be possible to maintain price stability with a relatively low real interest rate while supporting the emergence of the real local-currency depreciation that would foster the rapid recovery of exports once world demand revived.
The change in the policy mix agreed upon at the end of 2001 acted as expected from the end of December until February to change the composition of the publicís asset portfolio alongside rapid local-currency depreciation, expressed-also as expected-in relatively high price increases. It was anticipated that these would stop once the process of asset portfolio adjustment, in response to the one-off change in yield differentials, was completed. At the end of February and the beginning of March, however, it transpired that fiscal policy had not been adjusted so as to restore the deficit to the agreed path, private legislation was not revoked and, in addition, at the beginning of March an amendment to the Bank of Israel Law was proposed which would impair its independence and its ability to adhere to the objective of maintaining price stability. Against the backdrop of the exacerbation of the security situation, these developments towards the end of March led to the renewal of rapid local-currency depreciation, a rapid rise in actual and expected inflation, and to indications that financial stability was being undermined, among them a sharp rise in government bond yields. In this context, the Bank of Israel raised its key interest rate by a cumulative 5.3 percent over the period as a whole, and by 4.5 percent in June, in three stages. After these interest-rate hikes, and in view of the approval in May of a package of measures intended to check the increase in the budget deficit, a trend of local-currency appreciation and the return of the expected inflation rate to the region of price stability emerged.
The primary policy target for the coming years is to restore the economy to a path of sustainable growth, enabling employment to rise while maintaining financial and price stability and reducing unemployment and poverty. The macroeconomic policy mix that is consistent with these objectives involves replacing monetary expansion by credible fiscal restraint. A mix of this kind will facilitate the maintenance of price stability with a relatively low real short-term interest rate and the reduction of long-term real interest while supporting real depreciation. These measures will serve to increase investment and exports, and hence growth and employment.
In order to sustain a policy mix of this kind, fiscal policy must ensure adherence to the deficit target of 3 percent of GDP set by the government for 2003, as well as to its declining path, to reach one percent by 2007. On the basis of current assessments of the 2003 growth rate, it is reasonable to assume that attaining the deficit target will require considerable spending cuts. It is particularly important for the budgetary adjustment to be implemented on the (current) expenditure side, and not to increase the tax burden, as was the case in 2002, as any such increase will signal continued deviation from the declining deficit path and hamper the restoration of GDP growth. In order to support the return to a growth path, it is necessary to increase the share of infrastructure investment in the budget; this will contribute to growth by raising business-sector productivity. To make sure that the deficit target set is adhered to, along with the lower tax burden and expenditure levels that are consistent with it, the implementation of the budget will have to be monitored by means of periodic reports to the government and the public.
The rise in unemployment and the low labor-force participation rates require labor-market reforms. These should include the rapid reduction in the number of foreign workers, especially the illegal ones, making vocational training and retraining more efficient, adjusting the rules governing the minimum wage, and reducing the negative incentive to work implicit in transfer payments. In addition, the ongoing decline in productivity calls for structural reforms as well as increased efficiency and competitiveness in the principal industries.
An amendment to the Bank of Israel Law has recently been brought before the Knesset. If it is passed it will hamper the central bankís independence and ability to attain its objective of maintaining price stability. If and when the legislative process goes forward, it is important for the changes to adhere to the following principles, which are accepted in most advanced economies:
This Inflation Report was prepared at the Bank of Israel within the framework of the Senior Monetary Forum. The Forum-headed by the Governor-is the inter-departmental team (whose members include the heads of the Monetary, Research, Foreign Currency, and Foreign Exchange Control Departments) within which monetary policy decisions are taken.
1This document also serves as a Report on the Expansion of the Money Supply, in accordance with section 35 of the Bank of Israel Law, 5714-1954, following the 22 percent rise in the money supply from June 2001 to June 2002. The development of the monetary aggregates is described on p. of this report. Similarly, in accordance with cabinet decision no. 4167, this report notes that the inflation rate for 2002 is expected to be more than 2 percentage points above the upper limit of the inflation target range, and gives the reasons for this.
The full document, in zipped PDF file - 2.87MB